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Forex: US Dollar Trades Multi-Month Highs - What Could Derail It?

Forex: US Dollar Trades Multi-Month Highs - What Could Derail It?

David Rodriguez, Head of Product
forex_us_dollar_weekly_forecast_body_Picture_5.png, Forex: US Dollar Trades Multi-Month Highs - What Could Derail It?

US Dollar Trades at Multi-Month Highs – What Could Derail It?

Fundamental Forecast for US Dollar: Neutral

The US Dollar (ticker: USDOLLAR) traded to fresh five-month highs, as more hawkish-than-expected US FOMC rhetoric and a temporary deal on the so-called Fiscal Cliff sent the Greenback higher versus the Yen and other counterparts.

The US Dollar started the year considerably lower across the board as the US Government announced a temporary deal which averted going off the so-called Fiscal Cliff. Yet the Greenback quickly clawed back some of those declines as minutes from December’s Federal Open Market Committee meeting suggested that the Fed’s aggressive Quantitative Easing measures could end sooner than markets had previously expected.

A combination of further clarity on US fiscal and monetary policy helps explain why the US S&P 500 surged to fresh multi-year peaks, which hurts the US Dollar’s standing versus the risk-friendly Australian Dollar. That doesn’t change that the Greenback’s gains have been particularly versus the Japanese Yen, but aggressively one-sided USDJPY sentiment suggests that an end to gains may be near.

Looking to the week ahead, a number speakers fromthe US Federal Reserve headline an otherwise quiet week of US and broader economic event risk. A sharp drop in the US S&P 500 Volatility Index (VIX) suggests that domestic equity markets could head higher through near-term trade. Yet forex market volatility has not fallen nearly as much, and recent USD swings suggest that the coming days could produce similarly eventful price action.

Another potential source of economic uncertainty should feel familiar; the US Government’s recent deal to avoid the Fiscal Cliff set up another showdown for the upcoming test of the US Debt Ceiling. Economists estimate that the total US debt will reach the government’s self-imposed limit through mid-February, and there must be legislative action to enable further borrowing/avert fiscal insolvency.

It was during debtceiling negotiations in August, 2011 that Standard and Poor’s downgraded the sovereign rating of the US Government. Stock markets sold off sharply as a result and the US Dollar actually rallied against all major counterparts except the Japanese Yen. Similar acrimony in negotiations could cause similar uncertainty through February, and it will be critical to watch the next developments in debt negotiations.

The Dow Jones FXCM Dollar Index trades at its highest level since July, and current momentum favors continued USD strength. Yet there remain many questions unanswered, and it will be important to watch what happens in coming weeks as it relates to fiscal and monetary policy. US FOMC Minutes and the Fiscal Cliff solution theoretically brought clarity to both, but many things can happen to alter expectations and, by extension, affect the US Dollar itself. – DR

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

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